Market Place; Hollow Promises On Yields in Oil

By Floyd Norris

Published: November 7, 1989

IT was only a few years ago that independent oil and gas producers, having gone from Wall Street darlings to doormats, discovered that one way to raise cash was to promise high yields on the investment, with the added incentive that some or all of the yield would escape taxation.

Now, in many cases, investors who went for yields are discovering that such promises, even when kept, can be hollow. An example that appeared last week is Freeport-McMoran Energy Partners Ltd., an offshoot of Freeport-McMoran Inc.

When Freeport-McMoran Energy Partners went public in 1985, investors got what sounded like a tempting offer: a guaranteed 10 percent yield, much or all of it free from Federal taxes, in return for paying $22 per partnership unit.

That yield was guaranteed by the parent company for five years, and it has kept its promise. But the cost of keeping that promise has been a steady dilution in the stake of the partners, and the dividends have not been enough to offset the falling value of the partnership unit.

Now, Freeport-McMoran Energy proposes to convert itself from a partnership to a corporation, thus giving up some tax advantages. The company is hinting strongly that when it makes the conversion, its dividend will be cut radically, if not eliminated entirely.

That the dividend could not continue indefinitely was clear from a careful reading of the company's financial documents when it went public, and it remains clear today. The cash flow that investors should have looked at was that of Freeport-McMoran Energy, not the one that the parent promised to them. Freeport-McMoran Energy has never had the cash flow to pay that level of dividends to all unit holders. It managed to do so by having its parent take its dividends not in cash but in more partnership units, thereby reducing the relative ownership of the public partners.

Investors who bought at the offering in 1985, and paid $22 a unit, now hold units worth about $9.50 at recent prices on the New York Stock Exchange. These investors have also received $9.90 in cash and have a promise that they will get another $1.10. None of the payouts were taxable, because they counted as return of principal, which only reduces the holder's basis in the security. The partnership has not had taxable income to distribute.

These investors have, in other words, done a bit worse than they would have done by putting the $22 in a cookie jar and taking out 55 cents every three months. That, too, would be nontaxable.

That there are fads in the investment world is hardly news, but rarely are companies quite as open about being willing to take advantage of them. ''Market research has shown that while the oil and gas investor preferred yield securities during the 1980's, investors' interest, because of the outlook for energy into the 1990's, has been refocused on asset growth through additions to proved oil and gas reserves,'' explained James R. Moffett, the chairman of the parent company, in announcing the proposed change from partnership to corporation.

Now, Freeport-McMoran Energy plans to be viewed as a company that has growing assets. And that, at least, is a view that by recent history seems more accurate than the view that it was a cash generator. In both 1987 and 1988, the company managed to discover so much oil and gas that its proved reserves rose even before including acquisitions. Craig Saporito, a spokesman for the company, said that as a result of the expanded reserves, there were now about as much in the way of proven reserves behind each partnership unit as there were when the partnership was sold to the public in 1985.

Those reserves, alas, have not come cheaply. Freeport-McMoran Energy was forced to take a write-off in 1986 because the total value of its reserves was less than the amount it had invested in buying and finding them. Its acquisitions in 1987 and 1988 were for more than the value of the reserves, as computed by the method mandated by the Securities and Exchange Commission, requiring it to get waivers to avoid a write-down.

As of the end of 1988, however, the overall value of its reserves, including the acquisitions, was a bit higher than the value on the books: $1.238 billion, compared with $1.234 billion. That is not much of a margin, and it means that a further write-off could be coming this year, especially if oil prices weaken.

By changing from partnership to corporate status, Freeport-McMoran Energy hopes to attract more institutional investors, many of whom have been put off by partnership tax-reporting rules. But the switchover also threatens to provoke selling from individual investors as they realize that the high dividends are going to come to an end early next year. Whether the selling by yield-seekers will be offset by the buying of institutions remains to be seen.